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Investor Alert: Correction, Here We Come

It sure has been a nice ride. The U.S. stock market has not suffered a correction, or a pullback of more than 10 percent, in the 855 calendar days, and counting, since October 3, 2011. That streak, while still not in imminent peril, looks increasingly likely to end sometime soon.

January was the weakest month for both the Standard & Poor’s 500-stock index and the Dow Jones industrial average since May 2012. So far, February doesn’t look any better. On Monday, the S&P 500 and the Dow Jones industrial average each had their worst day since last June. The S&P tumbled 2.3 percent, finishing at its lowest level since October, while the Dow plunged about 2.1 percent on the heels of a worse-than-expected report on manufacturing activity in the U.S. in January.

“To a large extent, what’s really driving the market is the fact that it’s been two years since we’ve had a 10 percent pullback,” says Scott Wren, senior equity strategist at Wells Fargo Advisors.

Sentiment has clearly turned along with the calendar. At the start of the year, three quarters of investors surveyed by the American Association of Individual Investors said they were “bullish,” Jack Ablin, chief investment officer of BMO Private Bank, wrote to clients last week. Now, a relatively high portion of individual investors call themselves “neutral,” meaning they don’t know what to expect from the markets.

Coming off a year in which it sailed nearly 30 percent higher, the S&P 500 has now lost 5.8 percent in 2014. The Dow Jones industrial average has fallen 7.26 percent from its record high reached on the final day of last year. So while we’re not in correction territory just yet, the bulls have clearly been due for a breather — and global economic questions are providing plenty of reasons for that break to come now.

“What a difference a new year has made so far,” says Ablin. “We’ve had this rude and abrupt about-face. A lot of it is probably precipitated by a combination of grim headlines from the emerging markets, disappointing economic results here at home and a market that, frankly, started the year relatively overvalued.”

The Federal Reserve has made clear it is serious about continuing to reduce its rate of monthly bond purchases, announcing last week it would take another step in its tapering and cut the amount it buys by another $10 billion, to $65 billion. Concerns about the pace of growth in China, fueled by disappointing data, have injected uncertainty into the global economic outlook and spurred tumultuous selloffs in emerging market currencies. Those factors have all combined to inject more volatility into the market. The Chicago Board Options Exchange Volatility Index, or VIX, jumped 16 percent Monday to its highest close since December 2012.

“The combination of lower currency values, declining commodity prices and rising interest rates make further emerging market weakness increasingly likely. Consequently, investors seem to be less willing to take risk across many parts of the globe,” Gary Thayer, chief macro strategist at Wells Fargo Advisors, wrote to clients on Monday. “We believe decreased appetite for risk could weigh on global equity markets for another month or two until it becomes clear which countries will do better than others in this environment.”

The larger fears lingering over the market have overshadowed company-specific developments, David Kostin, chief U.S. equity strategist at Goldman Sachs, wrote in a recent note to clients. The market slump has continued since earnings season started on Jan. 9, but that isn’t necessarily because investors have been disappointed with the quarterly results being revealed. “Amazingly,” the Bespoke Investment Group pointed out in a blog post Monday, “the average stock that has reported so far this season has gained 0.39 percent on its report day.” That’s unusual in this kind of market environment, and it signals that investors are more attuned to big-picture risks and broad economic data than to corporate results.

“Unfortunately, macro factors have been outweighing the good micro news and investors are just unwilling to own stocks in general right now,” Bespoke’s analysts wrote Monday. “Earnings are the ultimate driver of stocks, and in our view, the fact that stocks are going up on their report days this season is a good sign for the long-term health of this market.”

Many market-watchers expect the recent volatility to continue, so investors may need to let the relatively placid pace of the recent rally fade from memory. Yet Wren of Wells Fargo Advisors says his firm has been telling clients that the volatility represents opportunity.

“We want them to continue to play the global economic recovery, which we think will continue at a modest pace,” he says, adding that Wells Fargo Advisors is most bullish on the consumer discretionary, technology and industrial sectors. “You don’t want to hide. You don’t want to get defensive. You want to look for sectors and industry groups and, ultimately, stocks that are sensitive to the global economy and have some exposure there. They’ll certainly have taken it on the chin in this pullback, and that’s where you need to step in and do some buying.”

Meanwhile, don’t look at your portfolio until further notice — at least not without a double Patron straight up.